“I immediately regret this decision… these bears are massive…they looked a lot smaller from up there.”
– Ron Burgundy: Anchorman
• THE BEARS AWAKEN – Fed Chair Powell’s Jackson Hole remarks have confirmed that a new rate regime has arrived: higher for longer.
• EAT MY SHORTS – Serenity’s short book has been profitable in 6/8 months in 2022.
• FUTURE 5-10 BAGGERS – Serenity’s watchlist contains companies with excellent long-term prospects that could generate explosive returns when we eventually exit the current bear market.
If you have ever camped in a national park, you know the rules for dealing with bears. Hide your food, keep your distance, and above all, do not mess with them.
The mid-summer stock market bulls learned this lesson the hard way in August.
Amidst hopes that the Federal Reserve was nearing the end of their rate-hiking campaign, Fed chairman Jerome Powell stepped to the podium in Jackson Hole (located in Grand-Teton national park…where warning signs regarding bears are everywhere) and delivered a short and succinct set of remarks that subsequently shook the capital markets.
The short version…the Fed is not done hiking and will not stop hiking until inflation is firmly under control. With a July CPI print of 8.5% this is clearly not yet the case.
A sheep in bears clothing, Jerome Powell is not.
It is important to remember that in the early 1980’s it took a fed funds rate of 19% to beat inflation that was running at 14%. The current fed funds rate is 2.3%, with inflation at 8.5%. What is the likelihood that the Fed can stop at 3% or 4% this time around?
Regardless of the fed funds level needed, the point is that the Fed must remain hawkish to truly tame inflation. That means they need to curtail demand…housing demand, apartment demand, hotel demand, anything pushing inflation up is the enemy of the Fed. Those fighting that tide eventually (and sometimes immediately) regret their decision.
At Serenity we remain vigilant for evidence that the winds battering the capital markets are abating or turning. At this point…we find very little of it. Our short book remains robust, our cash balance is large, and we continue to generate alpha relative to the benchmark and deliver less volatile returns to our clients.
With the bears awakening…have you done enough to protect your hard-earned portfolio?
PERFORMANCE: +0.64% in August, -10.0% YTD
Serenity Alternative Investments Fund I returned +0.64% in August net of fees and expenses versus the MSCI US REIT Index which returned -6.0%. Year to date, the fund has returned -10.0% net of fees versus the REIT benchmark at -18.3%, the NASDAQ 100 at -24.8%, and the S&P 500 at -16.15%.
On a trailing 3-year basis Serenity Alternatives Fund I has generated annualized returns of +17.0% net of fees and expenses. Over the same period, the REIT benchmark has returned +3.3% on an annualized basis. The fund’s Sharpe ratio over the past 3 years sits at 1.06, versus 0.17 for the REIT benchmark (remember higher is better, more return per unit of risk).
The largest positive contributor to the fund’s return in August was Nexpoint Residential (NXRT), a short position that fell -20.5% during the month. We have written about NXRT in previous newsletters as a well-run, fast-growing sunbelt focused Apartment REIT. Unfortunately, many of the attributes that make NXRT an attractive company in a bull market make it an excellent short during bear markets.
In particular, NXRT has high leverage, a high Beta coefficient, and exposure to lower income customers. Again, during a bull market, these are attractive qualities. They allow NXRT to grow earnings and cash-flows faster than peers and allowed it to be a top performing REIT from 2010–2019. During a bear market, however, these qualities cut the opposite direction. With economic data continuing to deteriorate, the Fed committed to hiking rates, and low-income customers the most impacted by inflation, NXRT looks like a compelling short bet. During August this thesis bore itself out to the tune of -20%.
The worst performing position in the fund in July was Prologis (PLD), a long position that returned -6.07% for the month. With the REIT index down -6% during the month, Prologis had in-line performance with the REIT universe. Over the long term, we believe the visibility of earnings and NAV growth for Prologis is superior to that of most REITs. PLD also sports a fortress balance sheet and a world-class management team. We are happy to ride a bear market out with PLD on the long-side and will add to our exposure if the stock becomes extraordinarily cheap.
THE BEARS AWAKEN: The Fed has spoken…higher for longer.
I would like to do something different this month and present excerpts from Jerome Powell’s late August speech with very little commentary. Frankly, his words speak for themselves. Remember these remarks came from the CHAIRMAN of the Federal Reserve…the guy steering the economic ship. Emphasis ours.
“Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance. Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions. While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.”
The fed is committed to bringing down demand, and inflicting pain on households and businesses to fight inflation. He is telling you to prepare for pain via higher unemployment. With the labor market continuing to add jobs…the Fed has a LONG way to go.
“Restoring price stability will likely require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy.”
Powell has clearly studied the 70’s, a decade in which the Fed prematurely eased policy on multiple occasions, leading to ever increasing inflation. He does not seem inclined to make the same mistake. Translation…higher for longer.
“Our monetary policy deliberations and decisions build on what we have learned about inflation dynamics both from the high and volatile inflation of the 1970s and 1980s”
See? I told you he studied the 70’s.
“It is also true, in my view, that the current high inflation in the United States is the product of strong demand and constrained supply, and that the Fed’s tools work principally on aggregate demand. None of this diminishes the Federal Reserve’s responsibility to carry out our assigned task of achieving price stability. There is clearly a job to do in moderating demand to better align with supply. We are committed to doing that job.”
The Fed cannot build houses. They cannot build semi-conductors or nuclear power plants in order to ease the world’s energy and supply crisis. They do have a blunt instrument with which they can hit the demand side of the economy, and they are smashing it like a one-year-old with a new drum set (I can send videos of this if helpful).
“These lessons are guiding us as we use our tools to bring inflation down. We are taking forceful and rapid steps to moderate demand so that it comes into better alignment with supply, and to keep inflation expectations anchored. We will keep at it until we are confident the job is done.”
Let’s think briefly about some game theory here. If the economy remains strong (employment, spending etc), the Fed must remain hawkish. Strength in the economy propagates inflation, and the Fed is very clearly committed to bringing inflation much lower. So the stronger the economy remains, the higher interest rates go.
If the Fed succeeds, that means firms are laying off workers, household incomes are moving lower, and a bankruptcy cycle is likely to ensue. There is a name for this…it’s called a recession.
Where does that leave us? Essentially the Fed MUST remain hawkish until the economy is in a recession. The BEST case scenario here is a soft landing…but even a soft landing means lower rents for Apartment REITs, lower occupancy and RevPAR for Hotels, lower consumer spending, and at the very least a significant loosening of the labor market.
As we mentioned above, with employment and spending still strong, the Fed has a long way to go. At Serenity, we are not interested in loading up our long book into peaking REIT earnings and a Fed committed to causing a recession.
SHORTS? If you got em, flaunt em.
Which brings us again to a key differentiator between Serenity and most real estate investment funds…the short book.
There is a cohort of investors that have been spoiled into thinking that commercial real estate prices can only go up. Over the past 12 years, this has mostly been the case, as any bout of economic weakness was met by a dovish Federal Reserve, tightening credit spreads, and lower interest rates.
As we discussed above, however, those days are now in the rearview mirror. Interest rates have moved meaningfully higher, credit spreads have expanded, and fundamentals very likely peaked in Q2 of 2022. The outlook going forward is for lower real estate values and lower cash flows.
And yet, most commercial real estate investors have done little or nothing to protect themselves from possible downside. At best some have delayed acquisitions, raised cash, or taken down leverage levels.
In our view, these measures are inadequate. My family and I have significant capital invested in our fund, and I have no qualms about being proactive in protecting it.
Enter the short book. Thus far in 2022, the short book has been our ally, positively contributing to the funds returns in 6 of 8 months of this year. This has enabled us to minimize the fund’s draw-down to ~-10%, while the REIT index has fallen as much as -20%.
Additionally, the short book will continue to act as a buffer if the economic and capital markets environments get REALLY bad. While a soft landing for the economy remains a possibility, in the event it occurs, most portfolios will be just fine. We believe our fund will outperform peers in that scenario, but the magnitude will likely be small.
If the Fed cannot thread the needle, however, there could be significantly more pain for the REIT market ahead, and we are one of the only firms on the street that can protect investor capital in that scenario. In fact, our investors are likely to GROW their capital in the event of a real bankruptcy cycle.
So the question remains…are you doing enough to protect your portfolio? At Serenity we continue to be pro-active, both hiding our food from the bears and taking out bear insurance. Our investors can sleep at night knowing their capital is safe, and their lunch is not going to be eaten.
5-10x BAGGERS: Fallen angels on the watchlist…
Despite our bearish outlook for the market in general, we continue to search diligently for long ideas, and have a growing list of companies that could be huge winners in the next bull market. These are companies that have strong long-term fundamental outlooks and histories of rapid revenue and EBITDA growth, but for various reasons have sold off in the current environment and are likely to remain at depressed levels until the economy truly turns (in the positive direction).
The chart to the right details the current valuations and return potential for each of these companies.
You will notice, 2 of the 3 companies trade at EBITDA multiples below 6x. For the sake of context, peers of these companies trade at EBITDA multiples in the 15x-25x range. Simply reverting to a sector average multiple would result in a 3-5x revision higher in valuation for both.
This can be glimpsed in the “return to max price” column in the table. Each of these companies has traded at a substantially higher stock price in the past and re-achieving these levels would lead to the returns displayed. Obviously, there is no guarantee that these “fallen angels” will ever achieve their former glory, but from our perspective, they are all facing cyclical as opposed to structural headwinds to their businesses. This means that once the cycle turns back in their favor, there is a good chance that investors will increase their risk appetites and drive these names substantially higher.
Now I have not included the tickers or descriptions of these companies here because they are high risk names. We believe they are cheap but may very well get much cheaper in the coming 6 months. We are content to wait and watch with all three of these companies until the economy improves. Our pencil remains sharp, and at the right time we will pounce and our investors will reap the benefits. We look forward to that day with monk-like patience.
THE LONELY BEAR: The only real estate fund that can protect your capital
For the first time in newsletter history, I felt it was appropriate to leave the title of our concluding remarks section the same as last month. In fact, it may not change until the economic headwinds of a hawkish Fed begin to fade.
Serenity remains one of the few commercial real estate investment funds that can proactively protect client capital amidst a bear market. We have a bench of compelling long ideas (3-5x baggers in the next cycle), an active short book of high-risk companies, and a book of tail risk hedges against capital markets disaster. We do not believe in holding REITs and hoping for the best. We invest capital opportunistically and protect it maniacally.
For any of our readers that have a much different view of the world, we would love to hear your thoughts. Is there a compelling bull argument that we have missed? We are always looking for holes in our own thought process, and therefore welcome constructive criticism. Don’t hesitate to tell us we are wrong!
Martin D Kollmorgen, CFA
CEO and Chief Investment Officer
Serenity Alternative Investments
Office: (630) 730-5745
**All charts generated using data from Bloomberg LP, S&P Global, and Serenity Alternative Investments
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